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Re: Inflation/Real Estate - CRE Trends / The Strong US Consumer & The "Ivan Drago" Fed.
I presented my Macro views on a panel this week alongside a bunch of CRE developers/operators/public REIT CEOs. Here is a summary of my learnings along with my Macro thoughts. Chatham Rules apply.
For the last several quarters, I’ve participated in several private roundtable discussions alongside a group of CRE developers/operators as well as public REIT CEOs.
Here is the last summary I wrote up from last year:
This week, I presented alongside such a panel of experts again, where I closed with my Macro views. This is a summary of my learnings and inferences, along with my own Macro presentation at the end, with Chatham House Rules applied.
Office CRE: Not Doomsday But Still a Story of Haves and Have-Nots
Since the collapse of SVB, there have been a lot of doomsday headlines of financings drying up leading to problematic CRE (specifically Office CRE) exposures for certain banks and insurance companies. One analyst posits that the truth might not be as bad as it sounds (thus far).
For instance, the total gross value of US CRE is $18.7T, with Office accounting for 15% of that, or $2.8T. Assuming average LTV of 60%, an average Default Rate of 50%, and an average 50% Loss Severity, Office CRE losses would amount to $420B in a rather draconian scenario — only 2.2% of total notional market size.
Source: UBS Investment Research
Furthermore, this is not a 2008-2009 scenario where capital availability completely disappeared. Class A Office mortgages are still getting refinanced, although demand for new loans is obviously much lower. While this is not great for developers in the space, it will ration supply away from some of the most problematic areas.
There is also a difference between Operational Distress vs. Financial Distress. Many Office properties are poorly financed but not necessarily operationally challenged — certainly not as bad as some of the doomsday headlines suggest.
Recourse Loans seem to be making a comeback in the wake of the post-SVB era, and the real test will be the ~$1.2T in upcoming Refinancings (across all CRE) in the next several years.
There is perhaps as much as ~$1T of institutional “dry powder” on the sidelines waiting for distress, and perhaps some of these funds begin to get deployed late 2023 and into 2024, which could cushion any shocks.
Between the continued availability of financing (albeit more expensive), better REIT balance sheets, and ample “dry powder” on the sidelines, the markets seem far better situated to weather this cycle than during the GFC era.
As an aside, I had a call earlier in the week with a large CRE lending fund that said they had financed a Class A Office property at the junior mezz level at 7.5% just a couple months ago. There is clearly a huge delta between Class A and non-Class A, and I’m sure there will be some serious casualties in non-Class A.
This reminds me of my own experience as a Convertible/Capital Structure Arbitrageur where I often observed Bonds that formerly traded on a “yield basis” rapidly transition to a “cents-on-the-dollar/recovery basis” once they enter the zone of Credit Distress. Similarly, I can see Class A CRE properties continue to trade on a “Cap Rate basis” while some non-Class A CRE properties crater to a “recovery basis.”
Retail CRE: Surprisingly Strong US Consumer Health
Debt cost-of-capital is averaging 7.5% for new debt in this sector, which is fairly restrictive for new growth. Transaction volumes have collapsed, although deal flow is starting to pick up a bit. Underlying fundamentals remain strong, but the financing markets are too weak to take advantage from a growth standpoint.
Recourse Lending also back in fashion here, and Regional Banks have become far more stringent on loans for Construction and/or Repositioning. Insurance Companies who have historically been a source of long-term debt financing are also more reticent given their overexposure to Office.
The US Consumer appears strong. Retail occupancies at one REIT are 98%, and “tenant demand remains strong, and tenant health is good.” Another operator said that Customer Counts were holding up well, although they have “dipped in the last 3 months.” This extremely data-intensive operator also mentioned that Customer Loyalty has been “increasing” and that Customer Sentiment remains “good.”
Some shopping centers have problems with idiosyncratic tenants (certain distressed big box retailers and drugstores, for instance), but grocery anchors and open-air centers remain solid.
Ample institutional “dry powder” — especially from Pensions — seems to also buttress this sector.
Homelessness and Crime are becoming issues, especially in states like CA, and Security as a cost line-item is way up from years past; one operator cited this line-item expense as his second biggest expense line now, where 65-75% of his shopping centers now require full-time security vs. only 10% ten years ago.
There were a lot of Retail Operators/Developers on this call, and the tone was surprisingly sanguine, with one person stating that “Retail has less room to fall in a recession, because it never got as expensive post-COVID.”
General CRE Bullet Points
The CRE environment is “confusing,” and it’s not entirely clear whether it’s a better time to buy or sell. Cap Rates obviously vary widely between CRE sectors but also vary between:
Private vs. Institutional Buyers, who typically pay 15% higher than Private but are currently absent from the market
East Coast vs. West Coast, with the West Coast typically commanding 50 bp lower Cap Rates (blowing out to 90 bps during COVID)
“Be patient and learn from the market.”
Macro predictions are very hard right now, so one should focus on Bottom-Up Value Creation.
Retail, Housing, Industrial seem to be areas of current investment interest.
“40-year low interest rate regime is over for good.”
Construction Financing is still available albeit at far more restrictive rates.
Construction Inflation in certain line items is still eye-popping (50% in “shell” construction, 200% in Concrete costs), although the “worst is likely over.”
From one Multi-Asset Operator: “The leasing market remains very strong.” This operator cited problems only with certain idiosyncratic big box retailers in distress.
Another Private Multi-Asset Operator cited Same Store Sales up 5% YoY and Rents up 5.5% YoY. This operator is already aggressively looking to buy in sectors where transaction volumes have collapsed.
Debt Maturities and Refinancings have yet to cause distress, but again, there appears to be ample “dry powder” waiting in the wings.
My Macro Presentation: The Ivan Drago Fed
I had the pleasure of closing the discussion by bringing everyone back up to a 30,000-foot Macro vantage point:
The Macro environment is indeed confusing, and I referenced my recent “Bottoms Up Macro” Substack, citing that Risk Assets seem drunk based upon 2 primary themes that might be mutually exclusive:
Hopes for Imminent Fed Pivot
Hopes for “Immaculate Disinflation” / Goldilocks
I pointed out that even the supposedly omniscient UST Yield Curve of Risk-Free Rates, which I consider to be the “Linchpin of all Financial Assets,” has been grossly and consistently wrong on the Higher For Longer trajectory for Rates. In my opinion, the pace of implied cuts is still mispriced:
Source: US Treasury Department
What appears to be a “Goldilocks” environment might be due to the “Destructive Interference” between Long-Term Demographic Tailwinds to Inflation and the Short-Term Monetary Headwinds to Inflation courtesy of the Fed.
Demographic Tailwinds to Inflation might be contributing to the stickiness of both Labor and Shelter components of CPI because there is a bulge in the 30-39 prime household formation/home-buying cohort at the same time there is a trough in the 45-59 most highly tenured pre-retirement Labor cohort:
Source: US Demographic Pyramid - 2025, Source: Zeihan On Geopolitics
The resilience of the US Consumer is coming from the resilience of the US Labor Market, but if the Fed’s only tool to counter what might be a Structural and Demographic Tailwind is to bludgeon the Economy into submission, it has a long way to go. The delta between the current 3.6% Unemployment Rate and the 4.6% Unemployment Rate soft target that the Fed deems necessary to slow Inflation to 2% is 1.5 mm jobs!!
The good news for Goldilocks is that the US Consumer is the strongest in the world, and the bad news for Goldilocks is also that the US Consumer is the strongest in the world. Why? Because the Rest of the World (RoW) can’t keep up.
The economic data coming out of the Eurozone and China in particular are horrendous. The industrial wheels seem to be coming off in Germany and in China.
If the strong US Consumer keeps up, the Fed will wind up staying Higher For Longer than anyone else, and the result will be a resurgence of the USD Wrecking Ball as everyone winds up Out-Doving the Fed.
Already, the RoW’s Central Banks are showing signs of capitulation.
7/27/23: ECB basically hinted that they’re done:
7/28/23: BOJ tried to show the world that they’re serious about fighting Inflation by instituting a “Weak Tweak” to their Yield Curve Control policy, which turned out to be a dud, and the JPY weakened on the news:
The biggest Elephant in the Room is China, and rather than re-litigate my case for why the CNY and HKD look vulnerable to Devaluation, here is my piece from last week that explains my logic in detail:
Whereas the US is trying to counter Long-Term Demographic Tailwinds to Inflation with Short-Term Monetary Headwinds (this is the “Destructive Interference” that gives us the illusion of a Goldilocks Environment), China is experiencing Short-Term Cyclical Headwinds due to its Property Bubble Collapse at the same time its Long-Term Demographic Headwinds are materializing (this is the “Constructive Interference” of two bad downtrends cascading into and augmenting each other).
To conclude, the Immaculate Disinflation / Goldilocks narrative is predicated upon the Strong US Consumer, but the very existence of the Strong US Consumer likely precludes an Imminent Fed Pivot which, through the USD Wrecking Ball as a transmission mechanism, could break one or both of the following:
The US Labor Market
Rest of World’s Economies, particularly China’s Economy, which would be hugely deflationary
The Fed has essentially become Ivan Drago from Rocky IV, but it’s not yet clear who his punching bag will be. One thing is clear though: the fight is going to get bloody, and someone is going to get hurt.
Re: Inflation/Real Estate - CRE Trends / The Strong US Consumer & The "Ivan Drago" Fed.
Global macro environment has undergone a paradigm shift.
PPP-weighted inflation was (is) lower in BRICS than in NATO countries.
Highest inflation happened in countries with contracting credit (surprise) and with fiscally tightening countries (surprise).
Only current account held its traditional relationship of higher inflation in deficit countries.